Snagging A Trophy Mall

They are beautiful, high-maintenance attention-grabbers and, usually, quite costly. Trophy malls, like trophy wives, are great eye candy. But look beneath the glitz and glamour of a tony mall and you'll find more than just lipstick and silicone. Turns out a trophy mall can boost a REIT's performance as well.

For years, the big public companies have been collecting the U.S.' most prestigious properties — those malls that produce the highest sales per square foot relative to their peers and dominate their market. General Growth Properties, Simon Property Group, The Rouse Co., The Mills Corp., The Macerich Co. and Westfield America Trust competed for $9.2 billion worth of these trophies in the first half of 2003, and the spree continues. Bidding wars for the increasingly scarce supply have driven cap rates to 7 percent and below. While some analysts have been cynical about the vanity of relying on variable-rate debt to pay low caps for trophies, there is growing consensus that they're worth it.

In a third-quarter report, Morgan Stanley analyst Matthew Ostrower said retail REITs outperformed all other REITs. Low interest rates, which bolstered consumer confidence and put more disposable cash in shoppers' pockets, have kept occupancy rates stable. During the third quarter occupancy was up 9.3 percent from the previous quarter and on average about 1 percent from the same period a year ago.

More importantly, the report says, strategic acquisitions have enabled owners to make multi-center lease deals with same-store tenants, thereby increasing their net operating income (NOI). “We deal with national chains with 150 locations, and certain locations, certain malls are important, depending on how you roll out the platform,” says John Bucksbaum, CEO of General Growth, which spent more than $4 billion in 18 months on market-dominating regional malls. While same store NOI growth has remained relatively flat throughout 2003, overall NOI was up about 2 percent in the third quarter, compared with the same period last year, and Mills and Rouse posted gains of 8.2 percent and 7 percent, respectively.

Reza Etedali, Sperry Van Ness senior vice president, suggests that this could be part of a paradigm shift as investors look for safe havens. “With current financing, investors are getting 6 percent to 8 percent returns on their investments — that's pretty good,” he notes.

In any case, says Bucksbaum, REITs aren't overly concerned about short-term returns. “Pricing makes it hard to make money on a buy, but we don't view property that way. When we buy a property, we don't anticipate what it will be worth in the future. We're looking at the value we can create while we own it.” At 15 percent, General Growth's returns are nothing to be ashamed of.

Barry Vinocur, editor of industry watchdog Realty Stock Review, suggests that the retail REITs, by-and-large, have displayed great discipline. “The market is awash with cash from a variety of difference sources — 1031s, private investors (who are now investing up to $200 million in a property), institutions, foreign investors,” he says. Properties are getting scarcer, pushing up prices on declining cap rates. Acquisitions by REITs must be approved by boards of directors, he notes, adding, “Management has to make a good case for doing a deal, and if it doesn't make sense, they don't do it.”

Macerich CEO Tom O'Hern agrees. “It's easy for an analyst to sit back and look at a number,” he comments, “but they don't do the due diligence the REITs have done.” A case in point is the Northridge Mall in Salinas, Calif., which Macerich acquired for $128.5 million, at an estimated cap rate of 7.3 percent in September 2003. Ostrower and analyst Susan Sorkin called the acquisition “pricey,” pointing out that this is a B-quality asset and the price paid was “significantly above 2003 B-mall pricing levels.” O'Hern defends this purchase, saying, “Salinas is the fastest-going city in the state and rents there are substantially below market. It's a great asset.”

Analysts are not as critical of Macerich's agreement to purchase Phoenix's Biltmore Fashion Park from Taubman for $158.5 million at a reported cap rate of 7.1 percent. O'Hern notes that this was the only major mall in Phoenix that his firm didn't own. “It made sense because it ties up that market, solidifying our presence in Phoenix.”

Although Smith Barney analysts Jonathan Litt and Ross Nussbaum say that Macerich “paid up” for this asset, they agree that this is a strategic move for Macerich and note that Biltmore is one of the strongest malls in the area. This deal is expected to close by the end of 2003.

Simon CFO Steve Sterrett says that with attractive borrowing rates, strong earnings and availability of unleveraged capital, there are multiple ways to ensure investors good returns. Like General Growth, says Sterrett, “We buy to hold, and I can't think of one purchase we've regretted.”

In August, Simon purchased the Stanford Shopping Center in Palo Alto, Calif., for $500 per square foot. “That was an attractively priced acquisition,” says Sterrett, “and we believe that rents currently are below market, because sales are generating $700 per square foot.” Sterrett put the cap rate at 8.5 percent, but Morgan Stanley analysts said it was more like 5 percent to 6 percent after subtracting payments for the project's ground lease from NOI. In November, Simon upped its interest in the upscale Kravco mall portfolio to 62 percent, giving it control of one of the U.S. top trophy malls — King of Prussia Plaza & Court in Philadelphia. The 2.9 million-square-foot super-regional is anchored by Bloomingdale's, Macy's, JCPenney, Neiman-Marcus, Lord & Taylor, Sears, Nordstrom, Strawbridges and a United Artists theater.

One major concern, however, is the amount of variable debt retail REITs are racking up.

While REITs have increased their variable debt and thus exposure to higher interest rates when the cycle changes, the Morgan Stanley report suggests that rising rates may displace highly levered buyers, causing cap rates to rise. That, in turn, could allow some retail REITs to offset some of their variable debt expense with profits from new acquisitions.

General Growth Properties' variable debt is 32 percent. Bucksbaum says his firm uses short-term debt to make acquisitions with minimal equity outlay. General Growth expects to create value in the first few years and pull the additional proceeds out of the property to service debt. “We have tremendous coverage to service the debt,” he says, contending the firm's coverage ratio is at an all-time high of 2.5 percent to 2.8 percent. Variable loans are converted to fixed after two to three years, Bucksbaum explains, contending that this strategy has worked well for 10 years.

O'Hern says that Macerich's short-term variable-rate debt was about 26 percent at the end of June. But, he noted, the company plans to do an interest-rate swap that will put variable rate exposure in the low 20 percent range in the next few months, when forward rate commitments and the swap are factored in. Sterrett says Simon uses a different model than its peers, leveraging its own assets to finance growth, and consequently has been able to keep its variable debt exposure at about 15 percent.

Urge to Merge

No one has a crystal ball, but with the current caps, REITs are stretching to buy, going back to committee to get the cap and IRR (internal rate of return) requirements lowered to compete with private investors, Etedali says. “I think that's why we'll see more mergers,” he adds. “Mergers provide an opportunity for certain REITs to buy underperforming REITs and increase their portfolios without competing with private investors.”

Those at the helm agree that there will be more mergers, with movement both from public to private and private to public. Noting that there's only a handful of mall REITs left, O'Hern notes, “There's already been a lot of consolidation in that sector, more than any other type, and we'll see more going private and more private to public mergers because it's tough to compete.”

Barriers to entry are high. “The nature of capital intense industries is to consolidate, so I expect this trend to continue,” Sterrett says, suggesting that small portfolios looking for exit strategies and a tax advantage will merge with public REITs, which have more capital.

He expects the number of regional mall owners to continue to dwindle, as public companies increase their ownership. Sterrett, whose firm recently lost a hostile takeover bid for Taubman Centers' portfolio, says that Simon will continue to eye friendly merger opportunities and also is looking at Europe for growth opportunities.